A defense of mortgage modification in bankruptcy.

Eric Posner makes a defense for allowing bankruptcy courts to modify mortgages.

If people can strip down their mortgages in Chapter 13, they will be less likely to abandon their houses, and this will have positive effects on their neighborhood. It is possible that such a rule could increase the cost of credit, as Todd argues, but the opposite effect is just as likely. On the one hand, banks might be reluctant to extend credit if they know that, in effect, repayment amounts will be reduced if housing prices decline, or banks will raise interest rates to cover this risk. On the other hand, if the result is a reduced incidence of foreclosure, then banks will do better rather than worse, and so interest rates should fall. If the right to modify the mortgage is limited to cases of financial crisis (which is not in the current bills), then the positive or negative effect on the cost of credit will be correspondingly smaller, minimizing a risk of disruption in the mortgage market.

We have learned from this crisis that every mortgage imposes potentially serious negative externalities on third parties. When someone defaults and abandons his house, he causes harm to others. The law currently does not punish that person or try to deter him from what is essentially a kind of pollution (like abandoning a car in the street); any attempt to do that would be impractical. So in a second-best world in which wrongdoers cannot be punished for the harm they cause others, restrictions on the contracts that bring about this state of affairs may well be justified. That is what bankruptcy law has always done; mortgage modification is a further development in bankruptcy law that would be justified in crisis (and possibly even normal) conditions.

Posner makes a fair argument and not unconvincingly, but there is one drawback that I see, if the Bankruptcy Courts have the power to modify mortgages, how many people will go the bankruptcy route versus how many will simply abandon their mortgage? There is little incentive for big banks to renegotiate mortgages for anyone having trouble if the result will be abandonment or forced modification by the Courts.